paris 2012 02 09 handout

Predicting the future: you know more than you think

Prof. Dr. Klaus W. Wellershoff

February, 2012

•  Lesson I: We know little about the future!

•  Lesson II: What we know is very powerful!

•  Lesson III: We spend a lot of time and effort to forget what we know!

2

Lessons learned…

... from 12 years as chief economist of a large bank:

•  Low interest rates imply:

•  lower returns on all asset classes

•  asymmetric expected returns

•  changed correlation patterns.

•  Forecast errors exist and the investment process needs to reflect this.

3

Things we know as money managers, …

... but rarely reflect on:

A low interest rate world

Impact of low interest rates on expected risk/return trade off

Money Market

Govt. Bonds

Corp. Bonds

Real Estate

Equities

Commodities

Private Equity

Expe

cted

Ret

urn

Systematic Risk

Traditional view

Consensus today

Wellershoff & Partners view

4

Source: Wellershoff & Partners

Source: Thomson Datastream, Wellershoff & Partners

Forecast Accuracy

Equity return forecast errors

0

10

20

30

Annualis

iert

er

Pro

gnosefe

hle

r (R

MS

E)

1 Monat 1 Quartal 1 Jahr 3 Jahre 5 Jahre 10 Jahre

5

Source: Goyal und Welch (2008), Wellershoff & Partners

1 Month 1 Quarter 1 Year 3 Years 5 Years 10 Years

An

nu

alis

ed R

oo

t M

ean

Sq

uar

e Fo

reca

st E

rro

r

Traditional portfolio construction

Standard optimization procedure

6

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0.5% 1.1% 2.0% 3.0% 4.0% 5.0% 6.5% 8.4% 10.7% 14.9%

Por

tfolio

com

posi

tion

Systematic Risk

Po

rtfo

lio C

om

po

siti

on

, S

har

e o

f A

sset

Cla

sses


Modern portfolio construction

Robust portfolio optimisation that reflects forecast errors

7

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

0.5% 1.7% 3.3% 5.0% 6.9% 8.9% 11.2% 13.9% 16.9% 20.7%

Por

tfolio

com

posi

tion

Systematic Risk

Po

rtfo

lio C

om

po

siti

on

, S

har

e o

f A

sset

Cla

sses


•  ... trend growth in this decade will be significantly lower than in the last.

8

Ecoonomic Certainties

We know that...

Future trend growth: World

Optimistic scenario

Growth contribution of population growth

-3

-2

-1

0

1

2

3

Per

cen

tag

e p

oin

ts

1950 1970 1990 2010 2030

USA Japan Germany

China India Switzerland

Investment-to-GDP ratio

0

10

20

30

40

50

60

Per

cen

t

1950 1970 1990 2010 2030

Growth contribution of factor productivity

-2

0

2

4

6

8

10

Per

cen

tag

e p

oin

ts

1950 1970 1990 2010 2030

Trend growth

0

2

4

6

8

10

12

Per

cen

t

2000–09 2010–19 2020–29 2030–39

Source: Penn World Tables, Wellershoff & Partners

Probability of recession

Major economies: 2010 - 2019

0

10

20

30

40

Rec

essi

on p

roba

bilit

y pe

r yea

r

UK US Germany Switzerland Japan

1990s

2010s

10

Source: Penn World Tables, Wellershoff & Partners


•  ... government revenue and spending eventually will have to be the same.

11

Economic Certainties

We know that...

Fiscal policy

Deficit in percent of GDP in 2011

10

5

0

5

10

15

Budg

et d

efic

it as

% o

f GD

P

United

States

Irelan

dJa

pan

United

Kingdo

mGree

ce

New Zea

land

France

Portug

alSpa

in

Sloven

ia

Slovak

Repub

lic

Poland

Canad

a

Hunga

ry

Austria

Denmark

Euro ar

eaTurk

eyIsr

ael

Belgium

Czech

Repub

licItaly

Netherl

ands

Estonia

Austra

lia

Icelan

d

German

y

Finland

Luxe

mbourg

Switzerla

ndKore

a

Sweden

Norway

12

Source: OECD, Wellershoff & Partners

Fiscal policy

Change in deficit/GDP-ratio since 2009

0

5

10

15

20

25

Perc

enta

ge p

oint

s ch

ange

in d

efic

it/G

DP

ratio

200

912

Irelan

d

Greece

Spain

Portug

al

Slovak

Repub

lic UK

Netherl

ands

Belgium

France Ita

ly

Finland

Sloven

ia

German

y

Austria

Luxe

mburg

Japa

n

Estonia US

13


Fiscal policy

Stability of debt/GDP-ratios

3

0

3

6

9

12

Perc

ent o

f GD

P

Switzerland Eurozone UK Japan US

Budget Deficit

Nominal GDP Growth

14




•  ... there is simply too much debt around.

15


We know that...

Real interest rates

Ex ante real interest rates from inflation protected bonds

Source: Thomson Reuters Datastream, Wellershoff & Partners

0

1

2

3

4

5

6

7

8

10Ja

hres

zins

en U

SA in

%

01/02 01/04 01/06 01/08 01/10 01/12date

Nominalzins

Realzins

Inflationserwartung




•  ... inflation forecasting does not work.

17


We know that...

Uncertainties

Forecast errors for CPI inflation over different time horizons

0.0

0.5

1.0

1.5

2.0

2.5

RM

SE o

f for

ecas

t erro

r

3 Months 6 Months 12 Months 18 Months 24 Months

US

Switzerland

18



•  ... government revenue and spending will have to be the same eventually .


•  ... inflation forecast models don‘t work at the moment.

•  ... GDP forecasts don‘t work at all, but leading indicators do.

19


We know that...

Uncertainties

Forecast errors for real GDP growth over different time horizons

0.0

0.5

1.0

1.5

2.0

Roo

t mea

n sq

uare

erro

r of f

orec

ast

Current 6 Months 12 Months 18 Months 24 Months TrendTime horizon of forecast

German Institutes 1998 2008

US Institutes 1990 2004

20

Source: Jochum (2009) & Patton and Timmerman (2010), Wellershoff & Partners


Investment Climate

Leading W&P-Indicator

0

10

20

30

40

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Today3 months ago6 months ago

USA

0

10

20

30

40

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Eurozone

0

10

20

30

40

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Germany

0

10

20

30

40

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Switzerland

0

10

20

30

40

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Japan

0

10

20

30

40N

umbe

r of m

onth

s

3 2 1 Mean 1 2 3

China

21


Consumption Climate

Leading W&P-Indicator

0

10

20

30

40

50

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Today3 months ago6 months ago

USA

0

10

20

30

40

50

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Eurozone

0

10

20

30

40

50

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Germany

0

10

20

30

40

50

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Switzerland

0

10

20

30

40

50

Num

ber o

f mon

ths

3 2 1 Mean 1 2 3

Japan

0

10

20

30

40

50N

umbe

r of m

onth

s

3 2 1 Mean 1 2 3

China


•  ... government revenue and spending will have to be the same eventually .


•  ... inflation forecast models don‘t work at the moment.

•  ... GDP forecasts don‘t work at all, but leading indicators do.

•  ... purchasing power parity works in the long run.

23


We know that...

Purchasing power parity (PPP) in the long-run

Producer prices in USD

24

Source Taylor & Taylor (2004)


Currencies: EURGBP

Actual and purchasing power parity (PPP)

.6

.7

.8

.9

1

1985 1990 1995 2000 2005 2010

EURGBPEURGBP PPPNeutraler Bereich

25


Currencies: EURUSD


0.60

1.00

1.40

1.80

2.20

1985 1990 1995 2000 2005 2010

EURUSDEURUSD PPPNeutraler Bereich

26


Currencies: EURJPY


50

100

150

200

250

1985 1990 1995 2000 2005 2010

EURJPYEURJPY PPPNeutraler Bereich

27


Currencies: EURCHF


1.2

1.4

1.6

1.8

2

1985 1990 1995 2000 2005 2010

EURCHFEURCHF PPPNeutraler Bereich

28

•  Expect to see

•  weak trend growth

•  the end of the trend of falling interest rates

•  more fiscal problems – debt crisis and/or fiscally induced slow-downs

•  Change your asset allocation

•  in all likelihood your strategy is wrong!

•  Remember the Alien Song!

29

Simple Conclusions

This report has been prepared and published by Wellershoff & Partners Ltd. This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis. Although all information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, no representation or warranty, express or implied, is made as to its accuracy or completeness. All information and opinions indicated are subject to change without notice. Some investments may not be readily realizable if the market in certain securities is illiquid and therefore valuing such investments and identifying the risks associated therewith may be difficult or even impossible. Trading and owning futures, options, and all other derivatives is very risky and therefore requires an extremely high level of risk tolerance. Past performance of an investment is no guarantee for its future performance. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in foreign exchange rates may have an adverse effect on the price, value or income of an investment. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we recommend that you take financial and/or tax advice as to the implications (including tax liabilities) of investing in any of the products mentioned herein. This document may not be reproduced or circulated without the prior authorization of Wellershoff & Partners Ltd. Wellershoff & Partners Ltd. expressly prohibits the distribution and transfer of this document to third parties for any reason. Wellershoff & Partners Ltd. will not be liable for any claims or lawsuits from any third parties arising from the use or distribution of this document. This report is for distribution only under such circumstances as may be permitted by applicable law.

30

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